The Benefits and Methods of Harvesting Your Losses, and Not Just at Year-end
By Robert Gordon, Twenty-First Securities Corporation and Jan Rosen, editor of The New York Times Tax Section.

Originally published in The Journal of Wealth Management, Fall 2001.  The material in this article is adapted from a chapter in Wall Street Secrets for Tax-Efficient Investing by Robert N. Gordon and Jan Rosen, published by Bloomberg Press, November 2001.

Taxable investors who focus on realizing capital losses only at year-end are leaving a lot of performance on the table. Knowing how - and when- to harvest losses can significantly mitigate the damage losses can do to your portfolio.

Despite the importance of loss harvesting as part of disciplined year-round portfolio management, the practice has received only a relatively small amount of attention from academics and practitioners.¹ In a recent study,² Robert D. Arnott, managing partner of First Quadrant, L.P, Andrew L. Berkin, Ph.D., associate director, and Jia Ye, Ph.D., conducted 400 Monte Carlo simulations, each with a universe of 500 assets.³ They thus generated a 25-year history of monthly returns subject to a 35% average tax rate for each asset. They found that the excess return generated from monthly lost harvesting was 80 (after-tax) basis points annually. They report: "Over a 25-year span, assuming modest 8 percent returns on stocks, we earn an average of almost 2,000 basis points of cumulative alpha just from harvesting the losses." They add: "and that's net of all of the taxes that you would face at the end of the period for liquidating the portfolio. It's a very important source of after-tax alpha, and it's both reliable and predictable."

Those results are quite consistent with Stein [1999], which reports a tax-management alpha ranging from 0.7% to 1.5% per year, on average, over a 10-year period for a large capitalization U.S. equity portfolio, assuming average market returns respectively ranging from 15% to 4%.⁴

Further, we are aware of a long/short hedge fund that proactively harvests losses and has generated almost 50 cents in losses for every dollar invested. But that is far from typical. Psychologically, it is difficult for many people to admit error, and consequently, studies have shown, investors tend to sell winners and hold losers in the hope that the losers will come back at least to where they bought them.⁵ And yet, for both maximum investment performance and tax efficiency, it is better to sell a portfolio's losers and hold the winners.

In this article, we address the rules, pitfalls, and methods investors may utilize in realizing losses in their portfolios.

Harvesting Winners And Losers

The simplest way to harvest losses when a portfolio has both unrealized winners and losers is to harvest them together. Because capital losses can offset capital gains dollar for dollar, an investor who believes a winner has had its run can sell it and avoid a tax on the capital gain by selling a holding with an equivalent loss. Under the tax code, short-term losses are taken first against short-term gains, and then long-term losses are taken against long-term gains. Finally, the net short-term gain or loss is taken against the net long-term gain or loss. If that results in a net capital loss, up to $3,000 a year can be taken against ordinary income, like salaries, dividends, or interest. Losses in excess of $3,000 can generally be carried forward to future years to be taken first against capital gains and then against ordinary income (with the same $3,000 limit).

The Jobs and Growth Tax Reconciliation Act of 2003 lowered the tax rate for long-term capital gain to 15% and the tax rate for ordinary income to 35%.

From a tax perspective, capital losses are most useful when applied against ordinary income or short-term gains, because long-term (that is, more than one year) capital gains are taxed at a maximum rate of 20%. That rate is just over half the top rate on ordinary income of 39.6%. This is an important factor to consider when deciding whether to recognize a portfolio loss.

Avoiding Wash Sales

But portfolios with paper losses do not always have paper gains that neatly offset them, and often investors still have faith in a holding that is under water. So the prob­lem becomes how to have it both ways: recognize the loss for tax purposes but keep the holding. That is possible, but investors must be mindful of the "wash sale" rules,⁶ which mandate that new shares cannot be repurchased for at least 31 days after any loss is realized. Various updates to the rules have been made to include wash purchases from unprofitable short sales and the reestablishment of suc­cessor positions using options.

Fortunately, there are ways to operate within the wash sale rules and keep the same economic exposure, but first let's look at the more traditional methods employed by investors and often recommended by brokerage houses,⁷ which do necessitate a change in the payoff pattern.

1. The first choice is to sell the stock and not reinvest for 31 days. Doing this, the investor would sacrifice any appreciation on the security during that time, and conversely would be protected from any further slide in its price.

2. A second choice is to sell the loss position and purchase another security that you believe will "act" like the original holding. Here the investor must weigh the viability of the possible substi­tutes. High-grade bonds seem the most homo­geneous as an asset class and the easiest to swap between, while small-cap equities seem the least interchangeable. In the real world, even blue-chip stocks in the same industry are not surrogates for each other. Within an industry, there are often both winners and losers.

Purchasing a bond of a different issuer, or purchasing a different bond of the same issuer but with a differ­ent interest rate and maturity, should allow the investor to deduct the loss and avoid running afoul of the wash sale rule. He or she might consider selling the bond to estab­lish the loss for tax purposes and then buying it back after 31 days. The waiting period is crucial. If an investor buys the same (or a substantially identical) security within 30 days before or after the date of the sale, the transaction is classified as a "wash sale," and the loss on the sale cannot be deducted .⁸

Doubling Up On Shares

An alternative long favored by tax advisers and port­folio managers has been to "double up." This involves buying an equal parcel of the security that has the unre­alized loss, and holding these shares along with the first lot a minimum of a requisite 31 days. At the end of the 31-day waiting period, the same number of shares is sold and the tax lot chosen is the first parcel of shares. This identification must be made with the broker. It should appear on the sales confirmation, and it could read "against shares purchased (original shares' purchase date)." Of course, while technically crafted to travel the wash sale rule safely, doubling up means the investor is being asked to assume twice the risk/reward.⁹

Doubling-Up Forward Conversion

Arguably, a far more effective approach that does not entail any additional risk is the doubling-up forward con­version that enables the investor to hedge all the risk of the second lot of shares. It requires additional capital, but the investor can earn a reasonable rate of return on that capital. Under this strategy, the investor purchases addi­tional shares of the underwater holding, doubling the original holding, buys a put on the new shares, and sells a call with the same strike price as the put on the new shares. This series of transactions - and the order of execution is important - enables the investor to recognize the loss while avoiding both a wash sale and any additional market risk:

Exhibit
Doubling Up Without Doubling the Risk

A transaction that has no risk should return the risk-free rate, not zero. This is the equivalent of earning interest on capital while invested for the legislated 31 days. We have recommended that clients execute the hedge with options on the underlying shares. Specifically we suggest selling calls and buying puts that have the same strike price and expiration (a forward conversion). Using the Exhibit above:

3/15/01
2nd 1,000 shares purchased at $10
Sell a call option with a $10 strike price
Buy a put option with a $10 strike price
Both have a 4/20/01 expiration

Net risk: 1,000 shares 3/15/01-4/20/01,
instead of 2,000 shares

To complete the example, the value of the call sold should (at today's rates) be 4 cents more than the cost of the put, netting a 6% annualized profit at expiration. If the shares are above $10, you can be sure they will be called away. If the shares are below $10, then the investor exercises his or her put to sell at $10. Either way the exit price has been contracted for at inception. Of course, the investor delivers the shares purchased on 9/12/90 to close the transaction.

This strategy can (and should) be used all year but cannot be put into place after November 30 for any given year because the necessary 31 days must occur before year-end.

Equity Swaps

For an investor with a sizable position, it has generally been thought possible to sell shares and immediately reestablish the position through the entering of a swap without running afoul of the wash sale rules. This belief was grounded on the basis that the rules applied only to stock and securities, and that swaps were not "securities." In addition, the wash sale rules apply if the investor sells stock at a loss and within 30 days enters into a contract to acquire such stock. However, on December 29, 2000, the wash sale rules were amended to include contracts that settled in cash or property other than the stock sold.

This amendment might cause swaps to be captured by the wash sale rules. When attention is focused on an effective method of avoiding taxes, Washington frequently moves to halt it. "Selling short against the box" had traditionally been the favored way to lock in profits without selling the shares until Estee Lauder and her son Ronald Lauder used it successfully when the family sold its cosmetics empire to the public in late 1995. Following public outcry at the transaction, the Clinton administration proposed regulations that were subsequently adopted to curb use of the strategy.¹⁰

Another disadvantage to swaps is that they are available only to those with larger positions (since most swap dealers have $3 million to $5 million minimums). We have found that the hedged double-up transaction is more widely embraced by the tax community, and thus we have seen most activity there. Significantly, however, a swap can be accomplished until the last day of the year. It should be noted that equity swaps are generally available for five years at most.

Writing Puts

Another transaction that alters the economic position of the investor but is still used is to sell the stock and immediately write a put on it. As the writer of a put option, the investor is obligated to purchase the stock if the holder of the put exercises it. As long as the stock remains below the strike price of the put on the expiration date, the put will be exercised.

The Internal Revenue Service has ruled that the writing of the put can violate the wash sale rules, if the strike price of the put is so far in excess of the stock's price at the time that it was written, that it is almost certain that the put will be exercised. If the exercise price is not too high, then the wash sale rule would be avoided. However, the investor will forfeit the appreciation in excess of the strike price of the put. Investors planning to use this strategy might consider using "European"-style options to avoid the early exercise of the put.

Conclusion

In conclusion, unrealized losses are an asset¹¹ that must be utilized in the desire to achieve the highest after-tax returns with the least amount of risk. Though there are several potential alternative ways to execute such transactions, two issues need to be analyzed:

1. Does the transaction create any incremental and unintended overall portfolio risks?
2. Does the cost of the transaction justify the anticipated tax benefit?

Answering these two questions will usually lead investors toward strategies such as the double-up forward conversion or the simultaneous purchase of a reasonably similar security, and away from the traditional approach involving doubling up.

Appendix

First Quadrant's 400 simulations encompassed a wide range of market conditions, from bull markets as good as (or better than) the most recent 25-year span and bear markets as bad as 1929 to 1953, a 25-year span in which the price of domestic equities fell.

In each simulation, the authors monitored two portfolios - a buy-and-hold portfolio and a tax-advantaged portfolio. In the buy-and-hold portfolio, the only transactions that occur are those forced by corporate actions like takeovers and mergers. The tax-advantaged portfolio was swept every month, and all assets with losses were sold and immediately bought back.

"For each month," the authors wrote, "we ask the simple question: if we were to liquidate both portfolios right now, how does the tax advantaged portfolio compare to the passive buy-and-hold benchmark, after all remaining taxes have been paid?" Even after 25 years, they found, the tax savings were around 0.5% a year, "an alpha that most active managers can't add reliably even before taxes."

After 25 years, they found, the median cumulative gain from loss harvesting was nearly 20%, or about 80 basis points a year. "Despite the fact that the simulation will cover scenarios with splendid returns and scenarios with awful returns," they said, "the range is surprisingly tight: from 60-100 basis points per annum is added through loss harvesting. Interestingly, the best value-added typically comes from the scenarios with lackluster returns: the opportunities to harvest losses, over a span of many years, are best if market returns are poor."

Endnotes

The material in this article is adapted from chapter in a forthcoming book by the authors entitled Wall Street Secrets for Tax Efficient Investing, to be published in November 2001 by Bloomberg Press.

1. See Roberto Apelfeld, Gordon Fowler, Jr., and James P. Gordon, Jr., "Tax-Aware Equity Investing," The Journal of Portfolio Management (Winter 1996), pp. 18-28; Jean L.P. Brunel, "The Upside-Down World of Tax-Aware Investing," Trusts and Estates (February 1997), pp. 34-42; Roberto Apelfeld and Jean L.P. Brunel, "Asset Allocation for Private Investors," The Journal of Private Portfolio Management (Spring 1998), pp. 37-54; David M. Stein and Premkumar Narasimhan, "Of Passive and Active Equity Portfolios in the Presence of Taxes," The Journal of Private Portfolio Management (Fall 1999), pp. 55-63.

2. Arnott, Robert D., Andrew L. Berkin, and Jia Ye. "Loss Harvesting: What's it worth to the Taxable Investor." The Journal of Wealth Management (Spring 2001), pp. 10-18.

3. The appendix presents some more information on the First Quadrant experiment.

4. The lower the market return, the higher the expected value added from tax management, as the lesser the build-up of unrealized capital gains in the portfolio.

5. See Hersh Shefrin, "Recent Developments in Behavioral Finance," The Journal of Private Portfolio Management (Summer 2000), pp. 25-38, for a discussion of this phenomenon, often called "the disposition effect" or "get-even-itis."

6. Internal Revenue Code, Section 1091.

7. See "Harvesting Your Equity Portfolio for Tax Efficiency," a special report for individual investors from Merrill Lynch, dated October 26, 2000.

8. But is not completely lost. It can indeed be incorporated in the tax basis of the security bought with the proceeds of the sale.

9. It can further be argued that the doubling-up strategy assumes that the investor always has excess cash available for such a purchase or that he or she can sell other shares - presumably without realizing too much of a gain. The incremental risks associated with these assumptions are equally important.

10. The New York Times, December 1, 1996, "Rushing Away from Taxes," by Diana B. Henriques and Floyd Norris.

11. Brunel [1997] argued that unrealized losses have many of the characteristics of a free option. Brunel [1999] takes the idea further, suggesting that the option value of volatility plays an important role in tax-efficient portfolio construction. See Jean L.P. Brunel, "The Role of Alternative Assets in Tax-Efficient Portfolio Construction," The Journal of Private Portfolio Management (Summer 1999), pp. 9-26.

This article and other articles herein are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein. Options involve risk and are not suitable for all investors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".